A Brexit deal is still no closer, but trade will not cease even if the March deadline passes

In the short-term UK and EU economic growth will suffer

Medium-term new arrangements will hold back capital investment

Long-term, there are a host of opportunities, in time they will eclipse the threats

In a departure from the my usual format this Macro Letter is the transcript of a speech I gave earlier this week at the UK law firm, Collyer Bristow; Thomas Carlisle may have dubbed Economics ‘the dismal science,’ but I remain an optimist.

Setting aside the vexed question of whether Brexit will be hard, soft or stalled, the impact on financial services (and, indeed, the majority of UK trade in goods and services) will be dramatic.

Financial markets (and businesses in general) loathe uncertainty. Ever since the referendum result, investment decisions have been postponed or cancelled. When investment is being made it is generally tentative and defensive. Exporters and importers alike are striving to develop alternative strategies to maintain and protect their franchises.

As a long-term economic commentator, I try to look beyond the immediate impact of events, since near-term expectations are usually reflected in the valuation of an asset or currency. Brexit, however, is a particular challenge, not only due to near-term uncertainty but because policy decisions taken now and in the wake of the March 2019 deadline could set the UK economy on an unusually wide array of possible trajectories.

Near-term

To begin an analysis of the impact post-Brexit on financial services, there are several near-term threats; here are a selection: –

House Prices

Earlier this month Mark Carney, the Governor of the Bank of England, warned cabinet ministers that a ‘no-deal’ on Brexit could see house prices decline by as much as one third and a rapid rise in defaults. The subsequent impact on financial institutions balance sheets and the inevitable curtailment of bank lending could be severe. Jacob Rees-Mogg even dubbed him, ‘The High Priest of Project Fear.’

Passporting

Assuming no deal is agreed, the access which financial services providers in the UK have had to the EU27 will not be available after March 2019. Many existing contracts and licensing agreements will need to be rewritten.

Regulatory equivalence

Divergence between the regulatory regime in the UK and Europe remains a distinct risk. The types of legal issues surrounding, for example, ISDA Master agreements (Deutsche Bank AG v Comune di Savona) will inevitably become more widespread.

Systemic Risks to the Euro

The ECB is vocal in its mission to maintain control over the clearing and settlement of Euro denominated transactions. Many financial services activities which currently take place in the UK may need to be transferred to another EU country.

In the near-term, these types of factors will reduce trade and economic growth, both in the UK and, to a lesser degree, in Europe. In May 2017 I wrote an essay entitled ‘Hard Brexit Maths – Walking Away’ in which I estimated the negative impact a no-deal Brexit would have on the EU. The UK’s NIESR estimated the bill for a Hard Brexit to the UK at EUR66bln/annum. I guesstimated the cost of Hard Brexit to the EU at EUR 62bln/annum. Both forecasts will probably prove inaccurate.

The reduced free movement of workers from the EU is another significant factor. It will lead to a rise in a toxic combination of skill shortages (due to new immigration controls) and unemployment, as companies are forced to conserve capital to weather the inevitable economic slowdown.

There are, however, several near-term opportunities, here are a small selection: –

Sterling weakness

The currency has already weakened. Whilst this may be inflationary it makes UK exports more competitive. Whether the UK can take advantage of currency weakness remains to be seen, history is not on our side in this respect.

A US boom

Aided by a lavish tax cut, the US economy is growing faster than at any-time since the financial crisis, underpinning its currency. Its trade deficit is growing despite tariff barriers.

US Trade policy

The Trump administration appears to have focused its ire on trade surplus countries, of which Germany is the largest European example. The UK is not under the White House microscope to the same degree.

Seizing the opportunity presented by these financial and geopolitical shifts is easier to speak of than to grasp. Nonetheless, just this month Absa Bank of South Africa (recently spun-off from Barclays) announced plans to open a London office to capitalise on post-Brexit opportunities connected with the fast-growing economies of Africa.

Medium-term

The medium-term risks will mostly be borne out of inertia. Until the shape of Brexit is clear, decisions will continue to be postponed. Once Brexit occurs there will be inevitable technical problems, stemming from systems issues and new procedures. Growth will slow further, business operating costs will need to be cut, employment in financial services (and elsewhere) will decline at exactly the moment when greater investment should be undertaken.

But, new trade deals will be negotiated, not just with Europe and the US, but also with the countries of the British Commonwealth, notably (but not just) India. Many of these countries are among the fastest growing economies in the world, often imbued with benign demographics. Here is a rapidly expanding working age population in need of capital investment and financial services. Ruth Lea, Chief Economist at Arbuthnot Latham has commentated on this subject at length during the last two years. In April she wrote: –

Commonwealth countries, taken together, have buoyant economic prospects and their share of global output continues to increase (especially in PPP terms). The EU28 share, in contrast continues to decline.

UK exports to the top eight Commonwealth countries rose by over 31% between 2006 and 2016, but total exports rose by 40%. And the share of UK exports going to the top eight Commonwealth countries fell from 7.5% in 2006 to 7.0% in 2016…

There is little doubt that Commonwealth countries have the potential to be significant growth markets for the UK’s exports, given their favourable growth prospects and demographics. This is all the more likely given the probability of trade deals with individual Commonwealth countries after Brexit.

Long-term

David Riccardo defined the law of comparative advantage just over two hundred years ago. Perhaps one of the best examples of the continuance of the phenomenon is Switzerland, which has seen its currency appreciate against the US$ by approximately 3% per year, every year since fiat currencies were freed from their shackles after the collapse of the Bretton Woods agreement in 1971. Here is a chart of the US$/CHF exchange rate over the period: –

Source: fxtop.com

The Swiss turned to pharmaceuticals and other value-added businesses. The success of this strategy, despite a constantly appreciating currency, has spawned an entire industrial region – the Rhone-Alp economic area, which incorporates German, French, Italian and Austrian companies bordering Switzerland. This region is among the most economically productive in the EU.

The UK has an opportunity, post-Brexit, to focus on economic growth. As a trading nation, we should concentrate our efforts on re-forging links with the fast-growing countries of the Commonwealth, where the advantages of a common language and legal system favour the UK over other developed nations.

An example of this opportunity is in education. We have a world class reputation for education and training. Combine this redoubtable capability with the abundance of new technologies, which permit the delivery of content globally via the internet, and we can provide the full gamut of instruction, ranging from primary to tertiary and professional via a combination of video content, on-line examination and tailored digital collateral.

A recent MOOC (Mass Open On-line Course) In which I enrolled, attracted students from across the world. The course was dedicated to finance and among the students with whom I interacted was a Masi tribesman from Kenya who hoped to develop micro-finance solutions for the local farming community. The world is our veritable oyster.

Conclusion – The Bigger Picture

The economies of the developed world are growing more slowly than those of developing nations. Providing goods and services to the fastest growing economies makes economic sense. Many of the largest companies listed on the UK stock market have been oriented to take advantage of this dynamic for decades. Brexit is proving to be cathartic, we should embrace change: the sooner the better.

The Austrian economist, Joseph Schumpter, described the cycle of economic development as including a period of ‘creative destruction’. Brexit could be an extreme version of this process. The patterns of trade which have developed since the end of WW2 have been concerned with promoting cohesion between European nations, but, as Hyman Minsky famously noted, ‘stability creates the seeds of instability.’ I believe the political polarisation seen in Europe and elsewhere is a reaction against the success of the global financial and economic system and the institutions and alliances created to insure its success. We are entering an era of change and Brexit is but one personification of a growing trend. Technology has shrunk the world, empowered the individual and (in the process) undermined the influence of nation states and international institutions. Individual freedom is ascendant but with freedom comes responsibility.

One of the greatest challenges facing the UK and other developed nations, in the long run, is the provision of pensions and health insurance to an increasingly ageing population. Many of the financial products required by these ageing consumers are ones in which the UK is a world leader. The developing world is rapidly growing richer too. Their citizens will require these self-same products and services. Brexit is an opportunity to look forward rather than back. If we embrace change we will thrive, if not change will occur regardless. Post-Brexit there will be considerably pain but, if we manage to learn from history, there can also be long-term gain.

The UK’s NIESR estimate the bill for Hard Brexit to the UK at EUR 66bln

I guesstimate the cost of Hard Brexit to the EU at EUR 62bln

Legal experts for both sides suggest UK obligations cease on Brexit

A Free-trade deal with the EU may not begin until after March 2019

…How selfhood begins with a walking away…

C. Day-Lewis

It has been estimated that if the UK accedes to EU demands for a further EUR 100bln in order to begin the process of establishing a bi-lateral trade deal with the EU post-Brexit, it will cost the UK economy 4.4% of GDP. According to estimates from the NIESR, to revert to WTO Most Favored Nation terms (the Hard Brexit option) would only cost between -2.7% and -3.7% of GDP (EUR 61bln to EUR 84bln).

In January UK MP May stated:-

No deal is better than a bad deal.

It looks, on this basis, as though the UK may indeed walk away from its purported EU obligations.

Depending on the scenario, the long-run net Brexit bill could range from €25.4 billion to €65.1 billion, possibly with a large upfront UK payment followed by significant EU reimbursements later.

This substantial price range is due to the way the UK’s share of liabilities is calculated. At 12% (the UK’s rebate-adjusted share of EU commitments) it is EUR 25.4bln. At 15.7% (the UK’s gross contributions without a rebate adjustment) it rises to EUR 65.1bln.

Article 50 provides for a ‘guillotine’ after two years if a withdrawal agreement is not reached unless all Member States, including the UK, agree to extend negotiations. Although there are competing interpretations, we conclude that if agreement is not reached, all EU law—including provisions concerning ongoing financial contributions and machinery for adjudication—will cease to apply, and the UK would be subject to no enforceable obligation to make any financial contribution at all.

Setting aside the legal obligations in favour of a diplomatic solution, what is the price range where a potential agreement may lie? The cost to the UK appears to be capped at EUR 84bln in a worst case scenario. One may argue that the ability of Sterling to decline, thus improving the UK’s terms of trade, makes this scenario unrealistically high, but as I discussed in – Uncharted British waters – the risk to growth, the opportunity to reform historic evidence doesn’t support the case very well at all:-

If devaluation solved the problems of the British Economy, the UK would have one of the strongest trade balances in the global economy…. the depreciation of sterling in 2008 did not lead to a significant improvement in the balance of payments. There was no “re balancing effect”. We always argued this would be the case. History and empirical observation provides the evidence.

There was no improvement in trade as a result of the exit from the ERM and the subsequent devaluation of 1992, despite allusions of policy makers to the contrary. Check out our chart of the day and the more extensive slide deck below.

1 Exporters Price to Market…and price in Currency…there is limited pass through effect for major exporters

2 Exporters and importers adopt a balanced portfolio approach via synthetic or natural hedging to offset the currency risks over the long term

3 Traders adopt a medium term view on currency trends better to take the margin boost or hit in the short term….rather than price out the currency move

4 Price Elasticities for imports are lower than for exports…The Marshall Lerner conditions are not satisfied…The price elasticities are too limited to offset the “lost revenue” effect

5 Imports of food, beverages, commodities, energy, oil and semi manufactures are relatively inelastic with regard to price. The price co-efficients are much weaker and almost inelastic with regard to imports

6 Imports form a significant part of exports, either as raw materials, components or semi manufactures. Devaluation increases the costs of exports as a result of devaluation

7 There is limited substitution effect or potential domestic supply side boost

Our analysis shows that if the UK leaves the EU without a trade deal UK exporters could face the potential impact of £5.2 billion in tariffs on goods being sold to the EU. However, EU exporters will also face £12.9 billion in tariffs on goods coming to the UK.

Exporters to the UK in 22 of the 27 remaining EU member states face higher tariffs costs when selling their goods than UK exporters face when selling goods to those countries.

German exporters would have to deal with the impact of £3.4 billion of tariffs on goods they export to the UK. UK exporters in return would face £0.9 billion of tariffs on goods going to Germany.

French exporters could face £1.4 billion in tariffs on their products compared to UK exporters facing £0.7 billion. A similar pattern exists for all the UK’s major EU trading partners.

The biggest impact will be on exports of goods relating to vehicles, with tariffs in the region of £1.3 billion being applied to UK car-related exports going to the EU. This compares to £3.9 billion for the EU, including £1.8 billion in tariffs being applied to German car-related exports.

The net Trade Effect of a Hard Brexit on the basis of these calculations is EUR 7.7bln in favour of the UK.

Then we must consider the UK contribution to the EU budget, which, if the House of Lords assessment is confirmed, will be zero after Brexit. This will cost the EU EUR7.8bln, based on the 2017 net EU budget of EUR 134bln, to which the UK is currently the second largest contributor at 5.8%.

Next there is the question of the impact on EU27 economic growth. These headwinds will be felt especially in the Netherlands, Ireland and Cyprus but the largest absolute cost will be borne by Germany.

According to a February 2016 study by DZ Bank, a Hard Brexit would be to reduce German economic growth by -0.5%, from 1.7% to 1.4% – EUR 18.5bln. Credit Agricole published a similar study of the impact on the French economy in June 2016. They estimated that French GDP would be reduced by -0.4% in the event of a free-trade agreement and -0.6% in the event of a Hard Brexit – EUR 13.2bln. The Netherlands Bureau for Economic Policy Analysis (CPB) estimated the cost to the Netherlands at -1.2% – EUR 8.2bln. Italian Government forecasters estimate the impact at -0.5 to -1% – taking the best case scenario – EUR 8.3bln. A leaked Spanish Government report from March 2017 (interestingly, the only estimate I have been able to uncover since the Brexit vote) indicates a cost of between -0.17% and -0.34% of GDP – again, taking the best case – EUR 2bln. Ireland, given its geographic position, shared language and border, has, perhaps the closest ties with the UK of any EU27 country. Back in 2016 the Irish ERSI estimated the impact on Ireland at only -1%, I suspect it might be greater but I will take them at their word – EUR 2.6bln.

In the paragraph above I have looked at just five out of the EU27. Added together the cost to just these five countries is EUR 52.8bln, but I believe it to be representative, they accounted for 84.74% of EU GDP in 2016. From this I arrive at an extrapolated cost to the EU of a Hard Brexit of EUR 62.3bln.

The European Commission has indicated that the cost for the UK to begin negotiating the terms of a new free-trade agreement with the EU may be as much as EUR 100bln. The cost to the UK, of simply walking away – Hard Brexit – is estimated at between EUR 61bln and EUR 84bln per annum. The cost of Hard Brexit to the EU is estimated (I should probably say guesstimated, since there are so many uncertainties ahead) at EUR 62bln. A simple cost benefit analysis suggests that both sides have relatively similar amounts to lose in the short term. And I hate to admit it, but looked at from a negative point of view, in the long run, the UK, with its structural current account and trade deficit, may have less to lose from simply walking away.

Conclusion and Investment Opportunities

Brexit negotiations are already and will remain deeply political. From a short-term economic perspective it makes sense for the UK to walk away and re-establish its relationships with its European trading partners in the longer run. Given the UK trade deficit with the EU it has the economic whip-hand. Working on the assumption that Jean Claude Junker is not Teresa May’s secret weapon (after all, suggesting ever higher costs for negotiating a free-trade deal makes it more likely that the UK refuses to play ball) one needs to step back from the economics of the situation. The politics of Brexit are already and will probably become even more venal. For the sake of the UK economy, and, for that matter the economies of the EU, I believe it is better for the UK to walk away To those of you who have read my previous articles about Brexit, I wish to make clear, this is a change of opinion, politics has trumped economic common sense.

The implications for the UK financial markets over the next 22 months is uncertainty, although May’s decision to adopt a Hard Brexit starting point has mitigated a substantial part of these risks. Sterling is likely to act as the principle safety valve, however, a fall in the trade-weighted value of the currency will feed through to higher domestic inflation. Short term interest rates, and in their wake Gilt yields, are likely to rise in this scenario. Domestic stocks are also likely to be vulnerable to the negative impact of currency weakness and higher interest rates on economic growth. The FTSE 100, however, with 70% of its earnings derived from outside the UK, should remain relatively immune.

Over the last three months, this has been typical of almost all financial media commentary. Sterling, meanwhile, has fallen, on a trade weighted basis, to a low not seen since the effective exchange rate index was recalibrated in 1990. At 73.79 it has even breached its close of December 2008 (73.855):-

Source: Bank of England

The recent weakness in Sterling has been linked to the publication of parts of draft cabinet committee papers, suggesting UK revenues could drop by £66bln. From a technical perspective the “Flash Crash” in Cable (GBPUSD) last week has exacerbated the situation, creating the need for the currency to retest the low of 1.18 during normal market hours – the market reached 1.2086 on 11th – more downside is likely:-

Source: DailyFX.com

As the two charts above reveal, Sterling has weakened by 16% versus the US$ and by 18.5% on a trade-weighted basis.

Here is the chart of GBPUSD since 1953. It reinforces my expectation, from a technical perspective, that we will see further downside:-

Source: fxtop.com

Given the seismic impact of a “Hard Brexit” on the UK economy, it would not be surprising to see a return to the February 1985 low of 1.0440.

I am not alone in my expectation of further weakness, Ashoka Mody – who organised the EU-IMF bailout of Ireland – told the Telegraph this week that Sterling was between 20% and 25% overvalued going into the Brexit vote.

Trade

The EU is the UK’s largest trading partner, accounting for 44% of goods and services exports in 2015 – though this was a decline the on previous year. Of greater concern to the neighbours, is the 53% of UK imports which emanate from the EU. In theory Sterling weakness should benefit UK exports; the impact has been minimal, so far:-

There was no improvement in trade as a result of the exit from the ERM and the subsequent devaluation of 1992, despite allusions of policy makers to the contrary.

…1 Exporters Price to Market…and price in Currency…there is limited pass through effect for major exporters

2 Exporters and importers adopt a balanced portfolio approach via synthetic or natural hedging to offset the currency risks over the long term

3 Traders adopt a medium term view on currency trends better to take the margin boost or hit in the short term….rather than price out the currency move

4 Price Elasticities for imports are lower than for exports…The Marshall Lerner conditions are not satisfied…The price elasticities are too limited to offset the “lost revenue” effect

5 Imports of food, beverages, commodities, energy, oil and semi manufactures are relatively inelastic with regard to price. The price co-efficients are much weaker and almost inelastic with regard to imports

6 Imports form a significant part of exports, either as raw materials, components or semi manufactures. Devaluation increases the costs of exports as a result of devaluation

7 There is limited substitution effect or potential domestic supply side boost

8 Demand co-efficients are dominant

If Sterling weakness will not improve the UK terms of trade, what will happen to growth? Again, in Macro Letter 59 I quote, Open Europe’s worst case scenario – that UK economic growth will be 2.2% less, on an annual basis, than its current trend, by 2030. Trend GDP growth between 1956 and 2015 averaged 2.46%. Is the media gloom justified and…

Are there any winners?

I concluded my July article saying:-

Companies with foreign earnings will be broadly immune to the vicissitudes of the UK economy, but domestic firms will underperform until there is more clarity about the future of our relationship with Europe and the rest of the world. The UK began trade talks with India last week and South Korea has expressed interest in similar discussions. Many other nations will follow, hoping, no doubt, that a deal with the UK can be agreed swiftly – unlike those with the EU or, indeed, the US. The future could be bright but markets will wait to see the light.

The UK stock market has already jumped the gun. The chart below shows the strong upward momentum of the FTSE100, dragging the, less international, FTSE250 in its wake; yet UK property has been hit hard by expectations of a slowdown in foreign demand:-

Source: Daily Telegraph

The obvious winners in the short term are companies with non-Sterling earnings – the constituents of the FTSE100 have an estimated 77% of overseas revenues – 47 of them pay their dividends in US$. The FTSE250 is not far behind, its members have 50% of foreign revenues. This is not dissimilar to the French CAC40 and German DAX. The table below lists the top and bottom ten FTSE350 companies by Sterling revenues:-

10 FTSE 350 companies with lowest sterling revenues

Company

Sterling revenues

Vedanta Resources (VED)

0%

Hikma Pharmaceuticals (HIK)

0.20%

BHP Billiton (BLT)

0.30%

Antofagasta (ANT)

0.40%

Mondi (MNDI)

0.40%

Tate & Lyle (TATE)

0.60%

Rio Tinto (RIO)

0.70%

British American Tobacco (BATS)

1%

Laird (LRD)

1.60%

Victrex (VCT)

1.80%

10 FTSE 350 companies with highest sterling revenues

Company

Sterling revenues

Saga (SAGAG)

69.80%

Capita (CPI)

70.40%

Wm Morrison (MRW)

70.60%

Booker Group (BOK)

70.80%

Intu Properties (INTU)

71.60%

Home Retail Group (HOME)

72.10%

OneSavings Bank (OSBO)

72.50%

Standard Life (SL)

88.90%

Grainger (GRI)

96.30%

Source: S&P Global Market Intelligence

Some of these companies are not exactly household names. Below is a table of the top 30 stocks in the FTSE100 by market capitalisation as at 28th September. The table also shows the year to date performance by stock as at 12th October:-

Company

Ticker

Sector

Market cap-£mln (28-09)

YTD (12-10)

>50% Non-£ revenue

% of non-£ revenue

Royal Dutch Shell

RDSA

Oil and gas

149,100

16.33%

Yes

85%?

HSBC

HSBA

Banking

113,455

15.97%

Yes

British American Tobacco

BATS

Tobacco

92,162

28.58%

Yes

99%

BP

BP

Oil and gas

81,196

25.99%

Yes

85%?

GlaxoSmithKline

GSK

Pharmaceuticals

80,629

32.02%

Yes

91%

AstraZeneca

AZN

Pharmaceuticals

64,771

18.72%

Yes

93%

Vodafone Group

VOD

Telecomms

59,259

6.10%

Yes

Diageo

DGE

Beverages

55,931

20.41%

Yes

Reckitt Benckiser

RB

Consumer goods

50,446

20.66%

Yes

Unilever

ULVR

Consumer goods

46,917

32.18%

Yes

85%?

Shire plc

SHP

Pharmaceuticals

45,899

16.56%

Yes

96%

National Grid plc

NG

Energy

41,223

15.14%

Yes

Lloyds Banking Group

LLOY

Banking

39,634

-29.62%

BT Group

BT.A

Telecomms

38,996

-15.03%

Imperial Brands

IMB

Tobacco

37,677

13.35%

Yes

Prudential plc

PRU

Finance

35,544

-3.61%

Yes

60%

Rio Tinto Group

RIO

Mining

34,715

6.72%

Yes

99%

Glencore

GLEN

Mining

30,135

94.96%

Yes

Barclays

BARC

Banking

28,089

-34.34%

Yes

Compass Group

CPG

Food

24,528

37.40%

Yes

WPP plc

WPP

Media

23,330

16.44%

Yes

87%

BHP Billiton

BLT

Mining

23,169

5.18%

Yes

97%

CRH plc

CRH

Building materials

21,314

50.45%

Yes

Royal Bank of Scotland Group

RBS

Banking

20,799

-46.12%

Associated British Foods

ABF

Food

20,481

-27.11%

Standard Chartered

STAN

Banking

20,403

-9.76%

Yes

Aviva

AV.

Insurance

17,925

-3.27%

Yes

60%

BAE Systems

BA.

Military

16,698

16.87%

Yes

RELX Group

REL

Publishing

15,842

27.83%

Yes

85%?

SSE plc

SSE

Energy

15,548

-1.75%

Source: Stockchallenge.co.uk, Financial Times

The table indicates where non-Sterling revenues exceed 50% and, where I have been able to glean current data, the most recent percentage of international revenues. These 30 names represent 70% of the total market capitalisation of the FTSE100 Index. The positive impact of the fall in Sterling on the performance of the majority of these stocks is unequivocal.

On a sectoral basis this is a continuation of the price action evident in the week following the Brexit vote. The chart below was published by the FT on 29th June:-

Source: Bloomberg, FT

The underperforming sectors are not difficult to explain. Banks and Insurance companies, despite having international revenues, have been hurt by concerns about the loss of access to EU markets after Brexit. Real Estate remains nervous about a collapse in international demand, now the UK is no longer the gateway to Europe. Meanwhile, the retail and household sectors are likely to suffer as UK economic growth slows, consumer spending declines, inflation – driven by higher import prices – squeezes corporate profit margins and the Bank of England is forced to respond to higher consumer prices with monetary tightening.

Yet, looking at the table below, the dividend cover of the consumer sector is robust and the data we have seen since Brexit – retails sales +6.2% in July and 6.3% in August, combined with the rebound in consumer confidence – suggests that the consumer is what might be deemed serene:-

Source: Daily Telegraph, Highcharts

Other UK economic indicators also seem to be rebounding. Manufacturing PMI was 55.4 in September –its highest level since the middle of 2014. Services PMI, at 52.6, is still expanding and Construction PMI, at 52.3, has returned to growth. Rumours of the death of the consumer may be grossly exaggerated. Even consumer credit, which dipped in July, rebounded in August.

The “Sterling Effect” on stock valuation has more to deliver in the near-term, but once the currency stabilises this one-off benefit will diminish.

Who will the longer term winners be?

It is difficult to assess the long run impact of a “Hard Brexit” without reviewing the WTO – Most Favoured Nation – Tariff schedule for the EU. The trade weighted average tariff for 2013 was 3.2%, but on agricultural products it was a much higher 22.3% whilst it was only 2.3% on Non-Agricultural products:-

Source: WTO

A “Hard Brexit” will probably entail a reversion to Most Favoured Nation terms with the EU under WTO rules.

The 18.5% decline in the Sterling Effective Exchange Rate means the cost to the UK of exporting, even agricultural products – excepting dairy – has been priced in. No wonder economists are busy revising their 2016/2017 growth forecasts higher – until Brexit actually happens, UK exports to the EU, and the majority of our other trading partners, will remain incredibly competitive.

Developing beyond this theme, a recent speech – The economic outlook – by Michael Saunders, a Bank of England MPC Member, reminded the Institute of Directors in Manchester:-

This by no means an exhaustive list – some sectors are an obvious response to the decline in the currency, others are rather less certain.

Tourism – with the UK suddenly an inexpensive destination for tourists from around the world. In 2015, 7.3mln tourists visited the UK, of which 4.6mln were from the EU. Tourism Alliance estimates the UK tourist industry was worth £126.9bln in 2013. The chart below shows the volatile but upward sloping evolution of tourism revenues:-

Source: Trading Economics, ONS

Here is an edited table of the Leisure and Travel constituents of the FTSE350, it excludes bookmakers, travel agents and airlines:-

Ticker

Company

CCL

Carnival

CINE

Cineworld Group

CPG

Compass Group

DOM

Domino’s Pizza Group

FGP

FirstGroup

GNK

Greene King

GOG

Go-Ahead Group

GVC

GVC Holdings

IHG

InterContinental Hotels Group

JDW

Wetherspoon (J.D.)

MAB

Mitchells & Butlers

MARS

Marston’s

MERL

Merlin Entertainments

MLC

Millennium & Copthorne Hotels

NEX

National Express Group

RNK

Rank Group

RTN

Restaurant Group

SGC

Stagecoach Group

WTB

Whitbread

Source: Shareprices.com

There should also be a positive impact on construction, as many operators, particularly within the unlisted sector, upgrade their facilities to capture the increased demand.

Not all the omens are positive; many of the jobs created by tourism are temporary and seasonal, the impact of a “Hard Brexit” is likely to lead to an increase in average earnings – good for employees, though not necessary for employers:-

Source: Trading Economics, ONS

The trend in wage growth has been steady for several years, but as inflation picks up and UK immigration declines, wages will rise.

Value Added Industries such as IT, Technology, Pharmaceuticals – these are growth industries in which the UK has a comparative advantage. Typically their growth is delivered through productivity enhancing innovation. That they will also benefit, from a structurally lower exchange rate, is an added bonus.

Property and Construction should recover strongly – according to the Nationwide, UK house prices increased again in September. Only in central London, where stamp duty increases on higher value properties has undermined sentiment, have prices eased.

The UK has a shortage of residential property. Whether interest rates remain low or not, this situation will not change until there is genuine planning reform. The three largest housebuilders Barratt Developments (BDEV) Taylor Wimpey (TW) and Persimmon (PSN) are all trading with P/E ratios below 10 times. The only real concern is the difficulty these companies may experience in securing skilled manual labour – Barrett Developments source between 30% and 40% of their current workforce from mainland Europe.

There are other companies in the construction sector such as Balfour Beatty (BBY) Carillion (CLLN) and Kier Group (KIE) which will benefit from increased public investment in infrastructure projects. Monetary policy is nearing the end of its effectiveness – although the central banks still have plenty of stocks they could buy. The next step is to pass the gauntlet back to their respective governments’. I believe fiscal stimulus on a substantial scale will be the next phase.

Banking and Financial Services may seem like the last place to look for performance. The regulators have been tightening the noose since 2008 – as the current crisis at Deutsche Bank highlights, this trend has yet to run its course. However, challenger banks and shadow banking institutions, including hedge funds, are beginning to fill the void. In the days before the financialisation of the economy, banking was the servant of industry. The real-economy still needs banking and credit facilities. The oldest of the Peer to Peer lenders (unlisted) Zopa, announced their first securitisation this summer. After a decade of development their business it is finally coming of age.

You may argue that the success of companies such as Zopa are based on technological advantages but the recent history of banking has been about harnessing technology to increase trading volumes and reduce the costs of financial transactions. Growth in the profitability of financial services is integrally tied to advances in technology.

A final argument for Banks is the FTSE350 Banks Index:-

Source: Bigcharts.com

The high in 2007 was 11,263, the low in March 2009, 2,782 – a 75% decline. The index nearly doubled in in the next six months, reaching 5,224 in September of the same year. This June the index failed to break to a new low after the Brexit vote. A base is forming – the banking sector may not have seen the last of fines and regulation but I believe the downside is limited.

Whilst I still think it most likely that we will vote to remain in the EU, if the UK electorate vote to leave the EU on 23rd June, this is what I believe may happen and here is one investment opportunity which might be worth considering:-

Short-term

Sterling will weaken, International capital outflows will hit UK stocks and Gilts. A “technical recession” will ensue.

Medium-term

A weaker currency will cause inflation and exports to rise. Higher yields and a more competitive currency will lead to capital inflows into UK stocks and Gilts. Sterling will recover.

Background

Governor Carney of the Bank of England sees the risk of a “technical recession” should the UK leave the EU. Christine Legarde, MD of the IMF, says she has “not seen anything positive” about Brexit in economic terms, predicting a rebound in growth if the UK remains, but the possibility of a stock and housing market crash if we leave.

The outcome would be to accelerate the shifting pattern of UK’s exports and total trade away from the EU to the emerging markets, where the majority of the world’s growth is located. A more business-friendly regulatory regime and the new security of the City of London from European interference will enhance competitiveness and compensate for the partial loss of access to the European market.

Elsewhere commentators talk of a “Neverendum” even in the event of Brexit.

What to do

The FTSE100 Index is slightly below the middle of its 2,000 point range of the last five years. Despite recent weakness, a Brexit vote will lead to a further weakening of the Sterling Effective Exchange rate. Capital outflows will hit stocks, however, a weaker currency will help the Bank of England to meet its inflation target and exporters will benefit, especially those trading with structurally faster growing economies such as China, India and a number of Commonwealth countries.

Prime Minister Cameron announced the date for the UK referendum on 20th February. The chart below compares the DAX against the FTSE and the S&P500 over the past six months. On the face of it the UK stock market has paid little notice of the vote, although the weakening of Sterling may have been supportive for the more international FTSE companies:-

Source: Yahoo Finance

Another interpretation of the price action in financial markets suggests that the markets expect the UK to remain. Similar price action proved more reliable than the opinion polls both during the Scottish Referendum of 2014 and the Quebec Referendum of 1995. Cable (GBPUSD) dipped in March but has since recovered, partly spurred on by initial polls predicting that UK voters would choose to remain, lately it has weakened once more. The charts below are from Wednesday 15th, the Sterling has weakened further since:-

Source: Barchart.com

EURGBP has been weakening over the past year:-

Source: Tradingview.com

When viewed over the past ten years, however, the nature of the price move appears less remarkable. Eurozone (EZ) growth has been improving after a period of protracted weakness. Could an improvement in sentiment towards the EZ be the catalyst rather than expectations of the demise of Sterling?

Source: Tradingview.com

Once the initial turmoil of Brexit subsides, fears about the stability of the Eurozone will return; during the last decade the UK witnessed “safe haven” investment flows from Europe, especially into real estate. Inflows will resume as the European political landscape polarizes further. The UK construction sector will benefit. Reform of planning legislation, more likely once the UK has regained control of its borders, could substantially increase the attractiveness of the building sector. In many ways the housing sector represents an each-way bet. Should the UK electorate vote to remain deferred demand for property is likely to resume.

The UK stock market dividend yield is around 4%: by other metrics, including the Cyclically Adjusted Price Earnings ratio, the market is not overly expensive either. A Brexit decline may provide an excellent buying opportunity. Prepare to invest.

Whilst the majority of articles between now and the 23rd June will focus on whether the UK will leave or remain in the EU and what this might mean, I want to consider the impact Brexit is likely to have on the long-run fortunes of the Euro.

Since December 2008 the EURGBP has fallen from 0.979 to a low of 0.694 in July 2015. Since the end of last year concern, about the outcome of a UK referendum on whether to remain or leave the EU, has seen the EUR strengthen to 0.810 – just over a 38.2% retracement. The UK economy has already begun to show signs of economic slowdown due to uncertainty. A vote to leave is likely to have a negative impact on the GBP, initially, if for no other reason than the continuation of uncertainty; neither the government nor the opposition has presented a road map for exit should the electorate decide to leave. In the event of a UK departure I could envisage a move back to 0.865 or even 0.971:-

Source: fxtop.com

I believe the impact on the UK economy of Brexit would therefore be a substantial weakening of the GBP, a rise in UK inflation and an initial slowing of economic growth. Our exports would rise and our imports would decline, improving our trade balance. Those European countries for whom the UK is their largest export market would suffer.

The cost of the UK leaving the EU would not stop there. The UK is the second largest member of the union. In terms of the economic and political strength of the EU, Britain’s inclusion is significant. By leaving the Schengen Agreement area we would impose higher costs on the remaining members, potentially hastening its interruption or demise. The ECIPE Five Freedom Project – The Cost of Non-Schengen for the Single Market published this week, provides an alarming vision of what that cost to EU growth might be:-

If Schengen would be suspended for the two-year period or even in full, trade and economic growth in the EU could be severely damaged. The Schengen Agreement is not just a symbol of European integration, it creates real economic value by facilitating cross-border exchange. Obviously, the Schengen Agreement promotes the free movement of people, but that is not all. It also boosts the flow of goods, services and capital across borders.

…In 2015 intra-EU trade in goods made up for approximately 60% of the EU’s overall trade.

…The Bertelsmann Stiftung estimated the impact of reintroduced border controls on the EU’s gross domestic product (GDP). Border checks which stop and control trucks cause time delays which increase transport costs and lead to higher product prices. According to their results these higher product prices can cause a yearly reduction in GDP growth of 0.04 percentage points compared to intra-EU trade with open borders. Furthermore, the study argues that the time delays at the border would make just-in-time production and decentralized production more difficult for European firms. As a result, production costs for intra-European value chains would increase and the price competitiveness of European producers would decrease. This could affect location and investment decisions by foreign firms.

A recent Ifo study finds that for EU member states the removal of border controls leads to an increase of 3.8% in goods trade or a cost saving equivalent to a tariff reduction of 0.7 percentage points for every internal border which a good needs to cross. As a result, countries which are at the periphery of the Schengen Area benefit more from the Agreement because their costs savings are greater if goods have to cross several borders until they reach their markets.

…upgraded Greek banks to “overweight” saying current valuations did not reflect the compression in bond yield spreads that would follow a deal with Athens’ lenders and took an overly pessimistic view on the banks’ return on equity targets.

Greece badly needs the next dollop of the €86 billion ($99 billion) bail-out creditors promised it last summer, in exchange for promises of austerity and reform. But it will not get the money until the creditors complete a review of its progress, which has been dragging on since November. The government has scraped together enough cash (by raiding independent public agencies) to pay salaries and pensions in May, perhaps even in June. But by July 20th, when a bond worth more than €2 billion matures, the country once again faces default and perhaps a forced exit from the euro zone. The threat of Grexit is not exactly back; it never really went away.

Italy’s new bank fund Atlas might be what is needed in the short run, but in the longer term the fund will increase systemic risk. What ultimately matters is how this initiative will affect the quality of bank governance, a key issue for the future resilience of the system.

…The Atlas fund has a heavy task, although probably not as heavy as that of its mythological namesake. In the short run, it might be what most commentators have described: an imperfect but needed second-best way to avoid bail-in and resolution, matching repeated calls from the Bank of Italy for a revision of the Bank Recovery and Resolution Directive (BRRD) framework after Italy negotiated and approved it.

However, by acting as a bank shareholder of last resort the fund increases systemic risk in the longer term, weakening the stronger banks and involving a publicly controlled institution whose main source of funding is postal savings into a rather risky venture.

While it’s unclear whether the aim is to keep foreign capital out of the Italian banking system, what ultimately matters is how this initiative will affect (or avoid affecting) the quality of bank governance, a key issue for the future resilience of the system. Regardless of whether we think that keeping weak banks alive at all costs is a good idea, the idea of such a shareholder of last resort appears at odds with the aim of making progress towards a solid European Banking Union.

Conclusion

The implications of a UK exit from the EU would, initially, lead to a strengthening EURGBP, although not necessarily EURUSD. This will be followed by a period of increased uncertainty about the survival of the Eurozone (EZ) during which the EUR will decline against its main trading partners. The chart below shows the Euro effective Exchange rate over the last 15 years:-

Source: Bluenomics, Eurostat

Once the first country leaves the EZ, sentiment will change once more. Investors will realise that the departure of the periphery strengthens the prospects of the currency union for those countries which remain; the EUR will begin to look less like a Drachma and more like a Deutschemark. The 2009 highs on the chart above will be within reach and a long-term trajectory similar to, though less steep than, the path of the CHF could become the norm.

For those who thrive on market volatility, over the next few years, opportunities to trade the EUR will be golden.

Uncertainty is bad for business and the UK will struggle ahead of the referendum

Gilt yields have been around 150bps higher than Bunds over the last 25yrs

The DAX has substantially outperformed FTSE over the same period

Higher productivity is key to UK growth but, in the long run, demographics will help

Last week the UK Prime Minister began to debate EU treaty reform with his European counterparts. He has a long way to go. The deadline for a UK referendum on EU membership is the end of 2017 but an up-hill battle is likely because all EU countries must ratify treaty changes – the referendum will come before EU treaty changes have been agreed. In this letter I will review the history of UKs, uncomfortable, membership of the EU and previous renegotiations, compared with today’s proposals. I will then go on to consider the implications for Sterling, Gilts and UK Stocks should the UK decide to stay or go.

A brief history of the UK and the EU

The last time the UK voted on EU, or as it was then called, European Economic Community (EEC) membership, was in 1975. At that time the “yes” vote won by 67.5%. This took place only two years after first joining, previous attempts to join in 1961 and 1967 having been vetoed by French President de Gaulle.

British scepticism about the political ambitions of the Schuman declaration of May 1950 meant the UK failed to join the European Coal and Steel Community – established at the Treaty of Paris in 1951 – but spent much of the decade debating EEC membership. When the EEC was finally established in 1958, the UK opted out for two principal reasons: concern about its relationship with the Commonwealth and other international alliances, and its preference for free-trade over economic organisation and sectoral policies. At that time the UK was torn between two foreign policy strategies, one focused on the European Free Trade Area, the other on the General Agreement on Tariffs and Trades – the predecessor to the World Trade Organisation (WTO).

The 1974 treaty renegotiation, just a year after joining the EEC, was driven by three factors: free-trade versus political integration, the effects of the collapse of Bretton Woods and subsequent inflation on the UK economy – Sterling had been considered a quasi-reserve currency up to this point – and the size of UK contributions to the EEC budget which the UK government considered to be excessive.

The table below lists the 1974 UK government demands for renegotiation and the outcomes:-

DEMAND

OUTCOME

Changes to CAP so as not to undermine free-trade

None

Fairer financing of EEC budget

Correcting mechanism

Withdrawal of UK from EMU

Accepted

Retention of UK powers over regional, industrial and fiscal policy

Creation of Regional Development fund supported by Ireland and Italy

Agreement on capital movement to protect UK jobs and balance of payments

None

No harmonisation of VAT

Never planned anyway

Access to Commonwealth goods

Minor concessions

The next major test of the UK relationship with the EU came during Margaret Thatcher’s first Conservative government (1979-1983) although an agreement with the EEC was not reached until her second term in 1984. On this occasion the issue was simply a question of how much the UK was paying in to the EU budget given that 80% of that budget was then spent on maintaining the Common Agricultural policy (CAP). The UK “rebate” was sanctioned because at that time the UK was the second poorest of the ten member EEC.

UK demands for treaty change 2015

The current UK renegotiation of EU membership is concerned with the following issues:-

Restrictions to freedom of movement within the EU

Sovereignty of Sterling

Structural reform of the EU bureaucracy

Reclaiming of powers from Brussels to protect UK interests

On the latter point, this takes two principal forms: the ability to block EU legislation where it may be detrimental to UK interests and the ending of a commitment to “ever closer union” in respect of UK membership.

The Sovereignty of Sterling is a relatively uncontentious issue, whilst structural reform of the EU bureaucracy is an ideal to which all European governments will accede, at least in principal; the problems arise over restrictions on free-movement of people – enshrined in Article 48 of the Treaty of Rome:-

1.Freedom of movement for workers shall be secured within the Community by the end of the transitional period at the latest. 2. Such freedom of movement shall entail the abolition of any discrimination based on nationality between workers of the Member States as regards employment, remuneration and other conditions of work and employment. 3. It shall entail the right, subject to limitations justified on grounds of public policy, public security or public health: (a) to accept offers of employment actually made; (b) to move freely within the territory of Member States for this purpose; (c) to stay in a Member State for the purpose of employment in accordance with the provisions governing the employment of nationals of that State laid down by law, regulation or administrative action; (d) to remain in the territory of a Member State after having been employed in that State, subject to conditions which shall be embodied in implementing regulations to be drawn up by the Commission. 4. The provisions of this Article shall not apply to employment in the public service.

This leaves, the reclaiming of powers from Brussels. “Ever closer union” is probably negotiable since EU member states have always moved at different rates, both economically and culturally. Allowing the UK to pick and choose which aspects of EU legislation it accepts, however, is like joining an exclusive club and then ignoring the rules. Under normal circumstances you’d be asked to leave.

One of the associated problems for the EU – that of, when to stop expanding – is discussed in this essay by Tim Price – Let’s Stick Together. He reviews the work of Leopold Kohr, in particular his seminal work “The Breakdown of Nations”:-

It all comes down to scale. As Kirkpatrick Sale puts it in his foreword to ‘The Breakdown of Nations’,

“What matters in the affairs of a nation, just as in the affairs of a building, say, is the size of the unit. A building is too big when it can no longer provide its dwellers with the services they expect – running water, waste disposal, heat, electricity, elevators and the like – without these taking up so much room that there is not enough left over for living space, a phenomenon that actually begins to happen in a building over about ninety or a hundred floors. A nation becomes too big when it can no longer provide its citizens with the services they expect – defence, roads, post, health, coins, courts and the like – without amassing such complex institutions and bureaucracies that they actually end up preventing the very ends they are intending to achieve, a phenomenon that is now commonplace in the modern industrialized world. It is not the character of the building or the nation that matters, nor is it the virtue of the agents or leaders that matters, but rather the size of the unit: even saints asked to administer a building of 400 floors or a nation of 200 million people would find the job impossible.”

Kohr showed that there are unavoidable limits to the growth of societies:

“..social problems have the unfortunate tendency to grow at a geometric ratio with the growth of an organism of which they are a part, while the ability of man to cope with them, if it can be extended at all, grows only at an arithmetic ratio.”

In the real world, there are finite limits beyond which it does not make sense to grow. Kohr argued that only small states can have true democracies, because only in small states can the citizen have some direct influence over the governing authorities.

What’s in it for the UK

In the interests of levity I’ve included a link to this summation of UK foreign policy with regard to Europe from the satirical TV programme Yes, Minister – this episode was first aired in 1980.

In the intervening 35 years, trying to decipher what is best for the UK has not become any easier. I’ve chosen just two organisations to represent the views for and against EU membership: Business for New Europe and Better off Out. Here’s how Business for New Europe make the case for staying in:-

As a member of the European Union, our companies can sell, without barriers, to a market of 500 million people. The Single Market means that exporters only need to abide by one set of European regulations, instead of 28 national ones. Europe is our biggest trading partner- it buys 45% of our exports. If we left the EU, companies would face tariffs and regulatory barriers to trade.

The free movement of capital means that EU companies can invest here in Britain freely. This investment, by companies like Siemens, creates jobs and grows our economy. 46% of all the foreign investment in Britain came from EU countries.

The EU provides funding for businesses to all regions of Britain, particularly those with the greatest need. From 2014 until 2020, £8 billion of EU money will go from Brussels to the UK. The biggest winners from this process are Cornwall, Wales, the Scottish Highlands, Northern Ireland and the North of England.

EU research funding helps universities and firms innovate to create the technologies of the future. Britain will receive £7 billion from the EU’s Horizon 2020 fund, and our small businesses receive more funding for hi-tech research than those of any other EU country. EU membership is vital to rebalancing the British economy.

1.Freedom to make stronger trade deals with other nations. 2. Freedom to spend UK resources presently through EU membership in the UK to the advantage of our citizens. 3. Freedom to control our national borders. 4. Freedom to restore Britain’s special legal system. 5. Freedom to deregulate the EU’s costly mass of laws. 6. Freedom to make major savings for British consumers. 7. Freedom to improve the British economy and generate more jobs. 8. Freedom to regenerate Britain’s fisheries. 9. Freedom to save the NHS from EU threats to undermine it by harmonising healthcare across the EU, and to reduce welfare payments to non-UK EU citizens. 10. Freedom to restore British customs and traditions.

They go on to highlight 10 Myths about the risk of leaving – not all are economic so I’ve paraphrased their opinions below;-

Britain would lose 3mln jobs if we left the EU – Under the terms of the Lisbon Treaty the UK would enter into an FTA with the EU. The WTO obliges them to do so too. Of more importance the UK trade balance will the EU is in increasing deficit – the other member states have more to lose.

Britain will be excluded from trade with the EU by Tariff Barriers – EU has FTAs with 53 countries with a further 74 countries pending. In 2009 UK charged customs duty of just 1.76% on non-EU imports. The EU Common Market is basically redundant already.

Britain cannot survive economically outside the EU in a world of trading blocs – Japan does and it’s not a member. The EU’s share of world GDP is forecast to be 15% in 2020, down from 26% in 1980. Norway and Switzerland export more, per capita, to the EU than the UK does. Britain’s best trading relationships are with the USA and Switzerland. The largest investor in the UK is US.

The EU is moving towards the UK’s position on cutting regulation and bureaucracy – EU directives are subject to a ‘rachet’ effect – once in place they are unlikely to be reformed or repealed. 80% of the UK’s GDP is generated within the UK so should not be subject to EU laws. In 2010, Open Europe estimated EU regulation had cost Britain £124 billion since 1998.

If we leave, Britain will have to pay billions to the EU and implement all its regulations without having a say – The UK has 8.4% of votes. The Lisbon Treaty ensured the loss of Britain’s veto in many more policy areas.

Swiss Case Study: The Swiss pay the EU less than CHF600mln a year for access to the EU market. They estimate the cost of full membership would be CHF3.4bln.

Britain will lose vital foreign investment as a consequence of leaving the EU – The 2010 Ernst and Young survey on UK’s attractiveness to foreign investors, found Britain still the number one Foreign Direct Investment (FDI) destination in Europe owing largely to the City of London and the UK’s close corporate relationship with the US. Key factors, in order of importance:-

Britain will lose all influence in the world by being outside the EU – Britain has a substantial ‘portfolio of power’ including membership of the G20 and G8, a permanent seat on the UN Security Council and seats on the IMF and WTO. The British Commonwealth has 54 nations which is being discriminated against by EU policy. London is the financial capital of the world and Britain has the sixth largest economy. The UK is also in the top ten manufacturing nations in the world.

Legally, Britain cannot leave the EU – A single clause Bill passed at Westminster can repeal the European Communities Act 1972 and its attendant Amendment Acts.

Having dealt with the main arguments for remaining in the EU, Better off Out do point out that creating an FTA with the EU may take time.

Greenland established a precedent when it left the EEC in 1985, this followed a referendum in 1982 and the signing of the Greenland Treaty in 1984. It had joined, as part of Denmark in 1973 but after it had achieved home rule in 1979 the importance of its fishing industry became a major economic incentive for it to leave the forerunner to the EU.

An EU without Britain would be smaller, poorer, and less influential on the world stage. The UK makes up nearly 12.5 percent of the EU’s population, 14.8 percent of its economy, and 19.4 percent of its exports (excluding intra-EU trade). Furthermore, it runs a trade deficit of £28 billion, is home to around two million other EU citizens, and remains one of the largest net contributors to the EU budget (responsible for 12 percent of the budget in total).

Meanwhile the Confederation of British Industry claim that being a member of the EU is worth £3,000 per household whilst Business for Britain estimate that the UK would save £933 per person from cheaper food if they left. In a report last week S&P chimed in, saying 30% of foreign direct investment (FDI) into the UK – representing 17% of GDP – was directed to financial services and insurance. 50% of this FDI emanated from other EU countries – this could be at risk if the UK should leave. So the debate rumbles on.

How is the UK economy evolving?

UK manufacturing has been in decline since the start of the millennium, whilst this decline was initially a reaction to the strength of Sterling it has yet to benefit from the subsequent weakness of the currency:-

Source: ERC, IMF, UN

Total factor productivity is near the heart of this conundrum:-

Source: ERC, ONS

The UK is lying 6th out of the G7 in terms of output per hours worked, and since 2007, has underperformed the G7 average. The dotted line shows where productivity would have been had the recession not hit. The UK had been lagging its peers during the 1990’s so the predicted outperformance would merely have brought it back into the fold.

Between 2000 and 2007, the average worker in the UK automotive manufacturing industry produced 7.7 vehicles a year. Over the past seven years he/she averaged 9.8 vehicles a year. Productivity – output per worker – in car manufacturing has increased by 30% since the onset of the great financial crisis. Britain has become the fourth-biggest vehicle maker in the EU and is more efficient than bigger producers such as Germany and France.

…Unfortunately productivity in the UK has not followed the lead of the car industry. Indeed, the opposite is true. In 2014 labour productivity in the UK was actually slightly lower than its 2007 level. In the seven years between 2000 and 2007 labour productivity grew at an average annual rate of about 2% a year. In the seven years that followed, our annual productivity growth averaged just below zero.

Or to look at it another way, the level of labour productivity – output per hour worked – in the UK economy is now 15% below where it would have been if pre-crisis trends had continued.

…It is true that the average output per hour of the rest of the G7 advanced economies is only around 5% above its pre-crisis level. But as I have noted, in the UK it has not even recovered to that level. And in 2013 output per hour in the UK was 17 percentage points below the average for the rest of the G7 – the widest gap since 1992.

…In the 10 years prior to the crisis, growth in the hours worked in the UK economy, accounted for 23% of the UK’s overall economic growth. The mainstay of our economic growth, the other 77%, came from growth in productivity. Since 2013 only 9% of our annual economic growth has come from productivity improvement. The remaining 91% has come from the increase in the total hours worked.

As a result, employment in the UK is now around its highest rate since comparable records began in 1971. Over 73% of people aged 16-64 are working. There are now over 31 million people in work in the UK. Unemployment has fallen at among its fastest rate for 40 years and is now very close to its pre-crisis level – over the past two years over 1 million jobs have been created.

…Productivity growth can be divided into two sorts of change: the change in productivity inside individual firms and the changes between firms. The first, the changes within firms, happens as firms increase their efficiency. The second happens as labour and capital are reallocated between firms, from the less productive ones to the more productive.

…After collapsing in the crisis, productivity began to increase again within firms two years ago. We expect that to continue. As the economy grows, spare capacity is used up. The real cost of labour increases relative to the cost of investment. Firms have a greater incentive to find efficiency gains and to switch away from more labour-intensive forms of production. This should boost productivity.

In contrast, productivity growth due to the reallocation of resources in the economy remains weak. We can see this in the divergence of rates of returns across firms which remain remarkably and unusually high and the change in capital across sectors which has been particularly low. When the reallocation mechanism is working, the transfer of capital and labour from the less productive to the more productive pulls up the level of productivity in the economy and reduces the divergence between firms. The high degree of divergence between firms at present implies that this reallocation mechanism is working significantly less powerfully now than before the crisis. This can also be seen in the proportion of loss-making firms which stands at around 20% higher than its long-run average. Company liquidations also remain low. So there is still more than a hint of ‘zombiness’ in the corporate sector.

The UK service sector continues to grow, although its share of exports to the EU remains smaller than that of goods – 37% vs 49%. Services exports to the rest of the world are the driver of UK export growth.

Conclusion and Investment Opportunities

Sterling

In search of a surrogate for the uncertainty surrounding the UK referendum, the chart below shows the impact on Sterling of the sudden realization that the Scottish might vote to leave the Union in 2014:-

Source: Oanda and ERC

Should the population of the UK vote to forsake the EU, the relative stability of the GBPEUR exchange rate is likely to become structurally more volatile, the move against the USD from 1.72 to 1.61 is but a foretaste of what we should anticipate. However, the 40% appreciation in the UK effective exchange rate between 1995 and 2000 – see the earlier chart above – and reversal between 2000 and 2009, suggests that membership of the EU has not led to the stability in exchange rates one might have expected.

Between the breakdown of Bretton Woods in March 1973 and the establishment of the European Exchange Rate Mechanism (ERM) In March 1979 (which the UK chose not to join until October 1990) was a period of intense currency volatility – exacerbated by significant interest rate differentials. During this period the GBP effective exchange rate actually moved less than it has since 2000. Nonetheless, higher daily volatility will impose a modicum of additional cost on UK businesses. This 2004 paper from the FRBSF – Measuring the Costs of Exchange Rate Volatility looks at the subject in more detail:-

The main quantitative finding is that the welfare effects of exchange rate volatility are likely to be very small for many countries. When numbers are chosen to permit the model to reproduce basic characteristics of the U.S. economy, the model indicates that the loss of utility is equal in size to only about 0.1% of annual consumption; that is, people would be willing to exchange only about 0.1% of their annual consumption level to eliminate the exchange rate volatility in the economy.

Gilts

The UK has exhibited structurally higher inflation than much of the Eurozone (EZ) since the collapse of Bretton Woods. That, combined with the relative asynchronicity of the UK and German economic cycles, made it difficult for the UK to operate inside the ERM – it lasted less than two years, from October 1990 to September 1992. The chart below shows German and UK 10yr Government bond yields during this period, Bunds, with lower yields, on the right hand scale:-

Source: Trading Economics

Germany was struggling during this period and the Hartz labour market reforms occurred shortly thereafter.

Source: Trading Economics

As the chart above shows UK Gilts have traded at a higher yield than German Bunds for most of last 25 years. I think it would be reasonable to assume Gilt yields, had the UK remained in the ERM and joined the Euro, would have been between those of Germany and France during this period. In other words, the cost of UK government financing has been around 150bp higher than it might have achieved had it joined the EZ.

UK inflation over the same period has been significantly higher than Germany’s, in real-terms Bunds have offered vastly superior returns. This differential may also be due to the UK government running a substantially larger budget deficit during the period. I regret the data in the chart below only goes back to 1996. The UK balance is shown on the right hand scale:-

Source: Trading Economics

Stocks

The chart below shows the relative performance of the FTSE100 vs Germany’s DAX40 since 1990. The German market (right hand scale) has increased from 2,000 to 12,000 whilst the UK market has risen from 2,000 to 7,000. Germany has been the clear winner of this race:-

Source: Trading Economics

Would the UK stock market have fared better inside the EZ and would the UK departure from the EU be detrimental or positive to stock performance going forward? Here is the 1990-2015 comparison between FTSE100 and the French CAC40 index:-

Source: Trading Economics

Germany appears to be something of an exception, France, Italy and the Netherlands have underperformed the UK during the same period: although Spain has delivered German-like returns. It is worth mentioning that Germany has run a balance of trade surplus for the entire period 1990 – 2015 whilst, excepting a brief period between 1991 and 1997, the UK has run a continuous trade deficit.

I don’t believe UK membership of the EU has much influence over the value of UK stocks in aggregate. Certain companies benefit from access to Europe, others are disadvantaged.

Unless the UK joins the EZ, currency fluctuations will continue whether they stay or go. Gilt yields will continue to reflect inflation expectations and estimates of credit worthiness; being outside the EU might impose greater fiscal discipline on subsequent UK governments – in this respect the benefits of EU membership seem minimal. The UK stock market will remain diverse and the success of UK stocks will be dependent on their individual businesses and the degree to which the regulatory environment is benign. The chart below shows UK GDP by sector since 2008. Services stand out both in terms of their resilience to the effects of the recession and continued growth in its aftermath, it is now 8.5% higher than before the recession, all the remaining sectors languish below their 2008 levels. Improving total factor productivity is key:-

Source: ERC and ONS

Ahead of the referendum, uncertainty will lead to weakness in Sterling, higher Gilt yields and relative underperformance of UK stocks. If the UK electorate decide to remain in the EU there will be a relief rally before long-term trends resume. If the UK leaves the EU, Sterling will fall, inflation will rise, Gilt yields will rise in response and the FTSE will decline. GDP growth will slow somewhat, until an export led recovery kicks in as a result of the lower value of Sterling. The real cost to the UK is in policy uncertainty.

Longer term the demographic divergence between the UK and other countries of Europe will become evident. By 2060 the working age population of the UK is projected to increase from 37.8mln (2013) to 41.8mln whilst in Germany the same population will decline from 49.7mln to 35.4mln. The EC – Ageing Report 2015 – has more details. The UK can benefit from staying in the EU and continuously negotiating. However, it must become much more involved in the future of the EU project, including “ever closer union”. It can also benefit from “Brexit”, directly flattering the government’s bottom line. The worst of both worlds is to remain, as the UK has since 1950, sitting on the fence –decisiveness is good for financial markets and the wider economy.